I have been monitoring the drop in commodity prices and the slowdown in the global economy since 2014. We didn’t think it would all lead to a global recession.
However, that is starting to look more likely, especially among some emerging economies.
In addition, manufacturing indicators weakened around the world during most of last year, including in the US. Germany and Japan also reported some disappointing data.
Nevertheless, we still aren’t predicting a global recession for this year. We could be wrong.
If so, what might be causing a recession this time with interest rates so low? It might be that interest rates have been too low for too long. When in doubt, blame the Fed.
Consider the following:
(1) High price of easy money.
Today’s problems may be mostly attributable to the termination of QE on October 29, 2014 and the subsequent anticipation of a mere 25bps hike in the federal funds rate, which finally happened on December 16, 2015.
The Fed’s easy monetary policies at the beginning of the previous decade certainly contributed to the subprime mortgage mess. This time, the Fed’s easy money in recent years encouraged borrowers in emerging markets (EMs) to borrow lots of money from banks and in the bond markets. A significant amount of that debt was in dollars. The prospect of the tightening of US monetary policy after so many years of near-zero interest rates caused EM borrowers to scramble to sell their own local currencies to buy dollars to pay off their dollar-denominated debts.
(2) Scrambling for dollars.
Fed officials have been either blithely oblivious or negligently unconcerned about how the “reach for yield” by investors in the US might have facilitated the capital flows into EMs, which now have been reversing, as evidenced by the 15.6% drop in Emerging Markets MSCI currency index since July 9, 2014.
The EMs have had to intervene in the forex markets to slow the descent of their currencies. Their non-gold international reserves have declined $838 billion to $7.4 trillion from July 2014 through October of last year. Of course, some of that decline is exaggerated by the depreciation of reserves held in euros and in yen, though that also has depressed the dollar value of reserves.
From this perspective, the 23% increase in the trade-weighted dollar since July 1, 2014 is to a large extent a massive short-covering rally by EMs. The soaring dollar increased the local currency prices of commodities priced globally in dollars. It’s likely that the plunge in commodity prices might have been triggered by the short-covering dollar rally combined with the tightening of credit for EMs. Of course, the supply-led glut of commodities only made things worse.
(3) End the Fed.
Fed officials don’t spend much time analyzing credit market developments and flows of funds, especially on a global basis. The Fed does have an excellent flow-of-funds database for the US. However, it lacks any data on credit derivatives, which might explain why Fed officials were blindsided by the subprime mortgage disaster. The Fed’s research staff conducted no significant research on mortgage credit derivatives prior to the previous financial crisis.
Similarly, this time around, the Fed mostly has ignored the impact of ultra-easy monetary policy on global credit flows, particularly to EMs. That analysis was left mostly up to the Bank for International Settlements (BIS), as we observed yesterday. Just as bad, Fed officials show virtually no interest in the dollar. They take no responsibility for its movements; nor do they try to understand the implications of these movements.
Let’s see if the FOMC statement this coming Thursday even mentions the soaring dollar and the plunging price of oil as possible reasons to postpone considering another rate hike anytime soon. We think it might, which might boost stock prices. So far, last year’s one-and-done seems to have done enough damage and might be more than enough for the foreseeable future.
(4) Are EMs subprime?
The fear, of course, is that all this is leading to another emerging markets crisis that could set off a global financial contagion similar to what happened in 2008. It’s actually surprising that nothing big has blown up so far. There could shortly be a Venezuela debt crisis, according to the financial press. My relatively optimistic spin has been that the dollar borrowing by EMs has been largely financed in the capital markets, which are better able to absorb shocks and losses than banking systems. Loans to EMs haven’t been sliced and diced into different tranches of credit derivatives as were subprime mortgages.
Of course, there are many high-yield bonds that were priced too cheaply and have seen their yields soar since mid-2014. However, they were never rated as anything other than junk. EMs and junk bonds have been great shorts recently, but I doubt there will be a sequel to “The Big Short” based on them.
(5) Global liquidity drying up?
While we are on the subject, the IMF publishes a monthly series on non-gold international reserves held by all central banks collectively and individually. The total increased by $5.3 trillion from March 2009 to its record high of $12.5 trillion during July 2014. Since then, it is down nearly $1.0 trillion to $11.6 trillion last October.
It was down 4.4% y/y during October, the eleventh consecutive monthly decline on this basis. It happens to be highly correlated with the yearly growth rate in the value of world exports. One of our accounts was alarmed both by the decline in reserves and by the 10.3% drop in world exports through October, the weakest growth since March 2010.
Remember, however, that both series are priced in dollars. The soaring dollar is depressing the dollar value of both reserves and exports, and all other global series priced in dollars. So keep in mind that the dollar is up 12% y/y when looking at the recent apparently weak growth rates of reserves and exports.
A more upbeat picture is provided by an index of the volume of world exports, which remained in record-high territory during November, gaining 2.2% y/y. The same can be said of world production, which was up 1.2% y/y during November. While these aren’t great growth rates, they are positive and in line with our secular stagnation scenario for the global economy, with neither a boom nor a bust.
The bottom line is that while the non-gold international reserves series may be an indicator of global liquidity, it isn’t a perfect one. Certainly, liquidity has dried up for borrowers in commodity industries. Foreigners wishing to borrow funds in dollars must also be facing more challenges, unless their revenues are in dollars. Yet the global economy continues to grow.
Dr. Ed Yardeni
is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.
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